Behavioral Finance

Case Studies

In late 2003, Apple started making iTunes for Windows, which in turn made the iPod compatible with the massive installed base of PC users, not just Mac users. The next couple of quarters showed an equally massive inflection point in iPod shipments, and revenues for Apple. From that point, Apple went on an incredible multi-year run.

Original Estimate

Actual Earnings

Actual vs. Estimate

2003

$ 0.30

$ 0.10

-67%

2004

$ 0.35

$ 0.36

3%

2005

$ 0.23

$ 1.56

578%

2006

$ 0.48

$ 2.27

373%

2007

$ 1.33

$ 3.93

195%

2008

$ 2.30

$ 5.36

133%

Source: FactSet

How far off was Wall St.? Way off (overconfidence). And, the analysts played catch-up for years, consistently underestimating Apple’s earnings power (anchoring). In this table, we have listed the original earnings estimate made by Wall St. analysts. These estimates were published about two years prior to the year which was being forecast. e.g. The original estimate for 2006 was first published in 2004.

While only trying to make an earnings prediction two years away on a very large company that is well understood, analysts still failed at getting anywhere near the actual results.

The chart above represents the results we seek to obtain for the Stephens Strategies when searching for securities for the portfolio. Upon the purchase of any security, we identify the criteria which would cause us to sell; including risk control, style purity, investment thesis plays out, management changes, etc...

Past performance does not guarantee future results. Diversification does not assure a profit or protect against loss in a declining market.

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Investing in small and mid-cap companies involves greater risk than investing in more established companies, including business risk, significant stock price fluctuations and illiquidity. Clients' investment results and principal value will fluctuate, principal loss is possible.

Status Quo Bias– The tendency to prefer that things stay the same. We have a hard time envisioning a future that’s remarkably different from the present. In this case, it’s that investors and analysts tend to assume things stay the same. People don’t like change.

Overconfidence effect– The tendency to believe that their judgments are more accurate than they actually are. Analysts that build earnings models for companies tend to be overconfident about their forecasts. This is evidenced by the relatively narrow bands that are created by their “best-case” and “worst-case” scenarios. Reality often lies outside of what experts think is best- or worst-case.

Anchoring– The tendency to rely too heavily on one piece of information or data set, and then base all future conclusions relative to the original data, even when the original data is random or uncorrelated. The anchoring bias is pervasive throughout Wall St. Investors and analysts can be anchored to an investment idea or belief (related to status quo effect). When forecasting earnings, analysts tend to make incremental adjustments to their existing models (anchor points), even when there is reason to believe that there has been a dramatic change.